Key Person Life Insurance: A Guide For Businesses And Employees

 

Life insurance is a valuable financial tool that can protect your loved ones in case of your untimely death. But did you know that there is a type of life insurance that can protect your business as well? It’s called key person life insurance, and it’s designed for businesses that have one or more employees who are vital to their success.

Key person life insurance is a life insurance policy that a business buys on the life of a key employee, pays the premiums, and receives the death benefit. A key employee is someone who is essential to the business’s operations, profitability, or growth. Losing this person would cause the business to suffer financially and operationally.

Key person life insurance is important for a business to protect itself from the loss and disruption caused by the death of a key employee. It can provide a financial cushion for the business to cope with the situation, help recruit and train a replacement, maintain customer and investor confidence, and preserve the value and continuity of the business.

In this article, we will explain what key person life insurance is, how it works, who needs it, what are the benefits of it, and how to choose the best policy for your needs and goals.

How Does Key Person Life Insurance Work?

Key person life insurance works similarly to a regular life insurance policy, but with some differences. Here are some of the basic features and mechanics of key person life insurance:

• Policy ownership: The policy owner is the party who has control over the policy and can make changes to it. The policy owner can be either the business or the key employee, depending on the type of arrangement.
• Premium payments: The premium payments are the amounts that are paid to keep the policy active. The premium payments are usually paid by the business, but they can also be shared with or reimbursed by the key employee, depending on the type of arrangement.
• Death benefit amount: The death benefit amount is the amount that is paid to the beneficiary of the policy when the key employee dies. The death benefit amount can range from a few thousand dollars to millions of dollars, depending on the coverage amount chosen.
• Beneficiary designation: The beneficiary designation is the party who receives the death benefit of the policy when the key employee dies. The beneficiary designation can be either the business or another party chosen by the key employee, depending on the type of arrangement.

The way key person life insurance is taxed depends on who owns the policy and how the death benefit is used. Generally speaking:

• If the business owns the policy and pays the premiums, it cannot deduct them as a business expense. However, it can receive the death benefit tax-free, as long as it meets certain requirements, such as obtaining the written consent of the key employee and notifying them of the coverage amount and beneficiary designation.
• If the key employee owns the policy and pays the premiums, they can deduct them as a personal expense if they itemize their deductions. However, they have to report the death benefit as taxable income, unless they name a spouse or a dependent as the beneficiary.
• If the business and the key employee share or reimburse the premiums, they have to allocate them according to their respective interests in the policy. The tax treatment of the premiums and the death benefit depends on their respective ownership and beneficiary designations .

Some of the factors that affect the cost and availability of key person life insurance are:

• The age, health, income, and role of the key employee: The younger, healthier, and more productive the key employee is, the lower the cost and higher the availability of key person life insurance.
• The type and size of the business: The type and size of the business can affect the amount and duration of coverage needed, as well as the eligibility and underwriting requirements for key person life insurance.
• The type and amount of coverage chosen: The type and amount of coverage chosen can affect the cost and availability of key person life insurance. There are two main types of coverage: term and permanent. Term policies provide coverage for a specific period of time, such as 10, 20, or 30 years. Permanent policies provide coverage for the entire lifetime of the key employee, as long as the premiums are paid. Permanent policies also have a cash value component that can grow over time and be accessed by the policy owner.

Who Needs Key Person Life Insurance?

Key person life insurance may be a suitable option for businesses that have one or more employees who are vital to their success. However, not all businesses may need or benefit from this type of policy. Here are some of the types of businesses and employees that may need key person life insurance:

• Businesses that have one or more owners, partners, executives, or managers who are essential to their success: These are people who have a significant stake or influence in the business, such as making strategic decisions, managing daily operations, overseeing key projects, etc. Losing these people would cause a major setback or disruption for the business.
• Businesses that have one or more employees who have specialized skills, knowledge, or relationships that are hard to replace: These are people who have unique or rare abilities or connections that give the business a competitive edge or advantage, such as developing innovative products, creating loyal customers, securing valuable contracts, etc. Losing these people would cause a significant loss or decline for the business.

• Businesses that have one or more employees who generate a significant amount of revenue or profit for the business: These are people who have a direct or indirect impact on the bottom line of the business, such as bringing in new sales, increasing productivity, reducing costs, etc. Losing these people would cause a substantial drop or shortfall for the business.
• Businesses that have commercial loans or investors that require key person life insurance as a condition: These are businesses that have borrowed money or raised capital from external sources, such as banks, lenders, venture capitalists, etc. These sources may require key person life insurance as a condition to ensure that the business can repay its debts or obligations if a key employee dies.

For example, let’s say XYZ Inc. is a software company that has three co-founders: Alice, Bob, and Charlie. Alice is the CEO and handles the business strategy and vision. Bob is the CTO and leads the product development and innovation. Charlie is the CFO and manages the financial operations and growth. Each co-founder owns 33% of the company and earns $200,000 per year.

XYZ Inc. decides to buy key person life insurance policies on each co-founder. XYZ Inc. owns the policies and pays the premiums, while each co-founder names their spouse as the beneficiary. Each policy has a $2 million death benefit and a 20-year term.

The key person life insurance policies benefit both XYZ Inc. and the co-founders. XYZ Inc. can protect itself from losing any of its co-founders, who are essential to its success. XYZ Inc. can use the death benefit to cover the costs of finding and hiring a replacement, maintaining its operations and reputation, and fulfilling its obligations to its customers and investors. The co-founders can protect their families from losing their income and ownership stake in the company. The co-founders can also receive tax-free death benefits if they die, or access the cash value of the policies if they leave or sell the company.

What Are The Benefits Of Key Person Life Insurance?

Key person life insurance can offer a number of benefits for businesses and employees who want to protect themselves from losing a valuable employee. Some of these benefits are:

• Providing a financial cushion for the business to cope with the loss of a key employee: Key person life insurance can provide a lump sum of money for the business to deal with the immediate and long-term effects of losing a key employee. The business can use this money to cover expenses such as recruiting, hiring, and training a replacement; compensating for lost revenue or profit; paying off debts or obligations; etc.
• Helping the business to recruit, hire, and train a replacement for the key employee: Key person life insurance can help the business to find and attract a qualified and suitable replacement for the key employee. The business can use the death benefit to offer a competitive salary and benefits package, provide training and mentoring, and ensure a smooth transition and integration.

• Maintaining the confidence and trust of customers, suppliers, creditors, and investors: Key person life insurance can help the business to preserve its reputation and relationships with its external stakeholders. The business can use the death benefit to demonstrate its financial stability and continuity, reassure its customers and suppliers of its quality and service, and fulfill its commitments and expectations to its creditors and investors.
• Preserving the value and continuity of the business: Key person life insurance can help the business to avoid or minimize the negative impact of losing a key employee on its value and continuity. The business can use the death benefit to prevent or reduce the loss of market share, competitive advantage, intellectual property, etc. The business can also use the death benefit to fund a buy-sell agreement or a succession plan, which can ensure a smooth transfer of ownership and management of the business.
• Offering tax advantages and flexibility for the business: Key person life insurance can offer some tax advantages and flexibility for the business, depending on how the policy is structured and used. For example, the business can receive the death benefit tax-free, as long as it meets certain requirements. The business can also choose the type, amount, and duration of coverage that suits its needs and goals. The business can also change or cancel the policy at any time, as long as it has the consent of the key employee.

How To Choose The Best Key Person Life Insurance Policy?

Choosing the best key person life insurance policy for your needs and goals can be challenging, as there are many factors to consider and options to choose from. Here are some tips and guidelines on how to find and select the best policy for you:

• Determine how much coverage you need and how long you need it for: You should calculate how much money your business would need to cope with the loss of a key employee, based on factors such as their income, role, contribution, etc. You should also estimate how long your business would need this financial support, based on factors such as your industry, market, growth, etc. This will help you decide how much death benefit you need and how long your policy term or duration should be.
• Compare quotes and rates from different insurers and agents: You should shop around and compare quotes and rates from different insurers and agents who offer key person life insurance policies. You should look for the best value for your money, not just the cheapest price. You should also check the reputation and ratings of the insurers and agents you are considering.
• Review the policy terms and conditions carefully: You should read and understand the policy terms and conditions carefully before signing anything. You should pay attention to details such as the premium payments, death benefit amount, policy term or duration, exclusions, limitations, riders, endorsements, etc. You should also ask questions if anything is unclear or confusing.

• Consider adding riders or endorsements to enhance your coverage or benefits: Riders or endorsements are optional features that you can add to your policy for an extra cost. They can enhance your coverage or benefits by providing additional protection or flexibility. For example, you can add a disability waiver of premium rider that waives your premium payments if the key employee becomes disabled; or a disability income rider that pays a monthly income to the business if the key employee becomes disabled.
• Consult a financial planner or an insurance expert if you have any questions or doubts: Buying a key person life insurance policy can be a complex and important decision that affects your business’s future and your key employee’s family. Therefore, you should consult a financial planner or an insurance expert if you have any questions or doubts about your options, needs, goals, etc. They can help you assess your situation, compare different policies, and choose the best one for you.

Conclusion

Key person life insurance is a life insurance policy that a business buys on the life of a key employee, pays the premiums, and receives the death benefit. It can protect your business from losing a valuable employee who is essential to your success. However, it is not the only option, and it may not suit everyone’s needs and goals.

Key person life insurance has several benefits for businesses and employees, such as providing a financial cushion, helping to recruit and train a replacement, maintaining confidence and trust, preserving value and continuity, and offering tax advantages and flexibility.

There are also alternatives to key person life insurance, such as group term life insurance, executive bonus plans, nonqualified deferred compensation plans, or individual term or permanent life insurance policies. Each alternative has its own advantages and disadvantages, such as cost, coverage, tax implications, eligibility, etc.

To choose the best key person life insurance policy for your needs and goals, you should determine how much coverage you need and how long you need it for, compare quotes and rates from different insurers and agents, review the policy terms and conditions carefully, consider adding riders or endorsements to enhance your coverage or benefits, and consult a financial planner or an insurance expert if you have any questions or doubts.

Key person life insurance can be a valuable financial tool that can help you protect your business from losing a valuable employee. If you are interested in buying a key person life insurance policy, you should start by contacting an independent insurance agent who can help you find and compare different options and guide you through the process.